With Frank Byrd, Founder of Fielder Capital Group
Warren Buffett Index Funds
Steve’s last guest today is Frank Byrd, a money management veteran, former Merrill Lynch financial consultant, chartered financial analyst, and founder of Fielder Capital Group.
Frank joins Steve to talk about Warren Buffett and his value investment strategy and, relatedly, the performance of index funds versus active portfolio management and why big money management firms are often a poor match for small-time investors. Steve kicks off the conversation by mentioning that he too worked for Merrill Lynch in a sales capacity at the beginning of his career in finance. He asks Frank to talk about his encounter with the reputation, writings, and strategies of Warren Buffett while he was still hammering away making cold calls to sales prospects. The back story to Frank’s discovery of Buffet is that during his sales work, he developed relationships with a number of older individual investors who had enjoyed a successful long-term track record in stocks. These investors tended to pick stocks of companies that they understood and had confidence in. With very modest beginnings, many of these investors had accumulated multi-million dollar portfolios over the decades.
Warren Buffett Value Investing
This experience – seeing an approach to investing that worked and trying to develop a repeatable strategy based on this success – was at odds with the Wall Street research Frank was reading at the time. A breakthrough came when a colleague brought him a copy of Buffett’s annual report for his company Berkshire Hathaway. Buffett’s commentary lined up with Frank’s observations and emerging investment philosophy and, as he put it, immediately “changed my life.” Finally, here was an approach to investing that simply made sense: “Buy shares of great businesses run by great people at good-to-great prices and hold them a long time.” This goes a ways towards describing the value investment philosophy in a nutshell. Steve describes a similar experience while working at Merrill Lynch when the head of research explained the core concepts of value investing, setting Steve on a path to discover Buffett himself.
Value-oriented Money Management
Frank began to attend Berkshire Hathaway meetings while researching other successful money managers that followed Buffett’s strategy of buying a small number of stocks and holding them for the long-term. These managers had the common denominators of low portfolio turnover (infrequent buying and selling), lack of “over-diversification” (low number of stocks), and a value orientation (understanding company balance sheets). Extensive research identified only a half-dozen managers with strong track records that followed these principles. Unfortunately, only half of these managed funds were open to new investors. The main question in Frank’s mind was why there so few managers with strategies guided by these concepts.
After Merrill Lynch, and still driven to learn more about Buffett’s and a mere handful of other manager’s approaches, Frank went back to school to get an MBA at Columbia University where Buffett himself studied under Benjamin Graham, the founder of value investing. Steve brings up a contradiction between, on the one hand, the widely held (as well as critiqued) idea in economics of “the efficient market,” which says that markets price in all known information about a company, thereby making it virtually impossible to get a jump, price-wise, on other investors and, on the other hand, Buffett’s seeming success at gaining just such an advantage over other investors. While some would see buying at a certain price as a kind of timing, Buffett’s commitment is to buying stocks at a reasonable price based on their financial fundamentals and holding for the long term.
Warren Buffett Bets On The S&P 500 Index
In a statement a few years back which seemed on one level to contradict his own success at actively picking a small number of stocks, Buffett shocked many by recommending that people should simply buy the S&P 500 index fund rather than seeking out successful fund managers. His argument, because of his legendary profile in the investing world, was received as putting professional money managers on notice, a conclusion he fully promoted. In fact, the statement should have been less shocking for those paying attention because he famously made a bet with a hedge fund, Protege Partners, in 2008 that after 10 years, an S&P 500 index fund would outperform any fund chosen by Protege’s manager. Eight years into the bet, Buffett’s position looks practically unassailable. He has recently amplified his criticisms of Wall Street’s money managers and their excessive fees and poor results relative to the S&P 500.
Frank describes the reaction among his friends to Buffett’s increasingly vocal stance on the superiority of index funds as curiously muted or, perhaps, not so curiously, given the professional and personal stakes for so many money managers. Frank believes that many of these fund managers would be relieved to see that their relative’s portfolios include index funds. He also describes the practice of “closet indexing” which many fund managers engage in which aims to create a sort of proxy for a major index like the S&P 500 by buying and weighting stocks instead of investing directly in a passively managed index fund.
For investors, the differences between a closet index fund and a straight up index ETF is that the fees and taxes are much higher on the closet index. Investing in the S&P itself through an index fund entails some “turnover”—buying and selling the individual stocks that compose the index—in the neighborhood of 5-10%, while that percentage for active fund managers running a closet index fund is closer to 100%. Because this turnover is taxed as capital gains, the result is a large difference in taxes. Discussing the “friction costs” of fees and taxes in more depth, Frank explains how the combination of manager’s fees, selling fees (12b-1), taxes, and, potentially, capital losses on stocks that have declined in value all contribute—especially in light of long-term compounding—to significant losses compared to index funds.
Large Money Managers And Dis-economies Of Scale
Despite these factors which favor index funds and Buffett’s disdain for Wall Street money managers, Frank thinks that Buffett’s analysis of index funds versus managed funds is actually more subtle. After all, Berkshire Hathaway itself is actively managed, and its results have been spectacular. Frank believes that the focus of Buffett’s critique is mainly on Wall Street’s largest money managers, who often win the business of large and small individual investors alike. Echoing Buffett’s comments, Frank suggests that these big managers experience “dis-economies of scale,” meaning that the more money under management, the worse the returns. Smaller, better-run funds limit their growth and turn away new investors because they understand this dynamic. Unless there are significant changes in the money management industry which allow smaller funds to proliferate, a major portion of large and small investor’s investment portfolios ought to be made of index funds. Frank concludes the conversation by admitting that he’s only ever hired one active fund manager at Fielder Capital Group—an expert on international allocations who quit after two months—which speaks volumes about his convictions on index funds.
Steve Pomeranz: My guest is Frank Byrd. He founded Fielder Capital Group and had worked for Merrill Lynch as a financial consultant years ago. He got his MBA from Columbia Business School, which is important to this story as you’ll hear a little bit later, and he’s a chartered financial analyst which makes him you a professional in a very professional business. I recently read an article that he wrote and realized that he and I have a lot in common, so I’ve invited him to the show to talk about, of all things, Warren Buffet. Welcome to the show, Frank.
Frank Byrd: Thank you, Steve. It’s great to be here.
Steve Pomeranz: So, you started in the brokerage world; you were very, very young, I understand, and you worked for Merrill Lynch. I worked for Merrill Lynch many years ago. It’s a high-pressure sales environment where people can make an awful lot of money and it was kind of a culture of just that—of trying to generate as many commissions as possible. Then you discovered Warren Buffet, I guess, relatively early on. How did that change you?
Frank Byrd: I had been at Merrill Lynch for about three years and having been a Political Science major not knowing anything, I naturally read as much research as I could, and none of it ever really sat with me. Then one day I walked into a senior broker’s office and he knew that. I kept asking him, “Why can’t we put money with money managers that do what I’ve seen succeed with the individual investors I’ve met?” Steve, by that I mean that I had been the cold-call cowboy. I made 40 cold calls a day for two years; that’s over 11,000 people. That obviously introduced me to a lot of real people; these were typically older investors. It takes a while to accumulate wealth.
And what I saw had worked for them was that they had bought and held shares of companies that they understood, many of them a regional company like a Federal Express, Procter & Gamble, Schering-Plough, Coca-Cola, and having bought several dozens of these over the course of many years, decades, they wake up with, many of them, very large portfolios. I’m talking a million dollars, and that’s in the early 1990s in Memphis, Tennessee, mind you.
So, I knew that that worked and, to be clear, these weren’t high-income professionals. Many of these were people that had never made over $50,000 a year. So, I knew what worked. I saw it. And, unfortunately, everything I read with the typical Wall Street research didn’t really sit with me because I couldn’t tie it to reality. And one day, accidentally, this broker said, “Hey, I’ll bet you’d like this.” I picked up the Berkshire Hathaway report. I took it home that night, and it changed my life. For the first time, I read something that made sense: Buy shares of great businesses run by great people at good-to-great prices and hold them a long time. Like, that works. I can sell that because it’s the truth.
Steve Pomeranz: Yeah. You could believe in what you were actually selling because you had the sense that these things worked. I had a similar experience myself. When I worked for Merrill Lynch, there was … the head of research there was a value manager and he would espouse the concepts of value investing and that’s really the first time. Nobody ever trained me on any of this stuff. It was always, you know, you go to New York and you learn how to sell options. You learn how to trade bonds and things like that but nobody ever actually said, “Here’s an investment philosophy.” So that’s when I got introduced to Warren Buffet. Plus, you know his plain-spoken way and his ability to kind of use common sense as a platform for explaining how things worked really did resonate with me.
Now, Frank, you then decided to go back to school, and you went back to Columbia, or you went to Columbia, right?
Frank Byrd: Absolutely. I went to several Berkshire meetings. I read everything I could about this person, and he genuinely changed my life. I finally made up my mind …and back then, I was looking for money managers who were investing in the way that I knew Buffet invested, which, simplistically put, meant they didn’t own that many stocks. They weren’t over diversified; they had a value orientation, and they had a very low portfolio turnover. They were very close to buy-and-hold. When I did a search on this big database, and, in the mid-90s, it spit out, Steve, literally, I think, there were six managers it spit out of this search among thousands of managers that had a decent track record. I think I was looking for five years or more, that were practicing this craft, and I remember many of the six firms that were on that list, half of which were closed to new investors.
So, I said, “Hmm, there must be a shortage of people out there that are doing this so why don’t I go off and learn how to do it myself?”
Steve Pomeranz: So, you went to Columbia because Buffet …well, that was Buffet’s alma mater and that’s where he worked with Ben Graham and followed the Graham and Dodd philosophies of investing. You actually went right to the source; that’s really pretty commendable.
All of these years have gone by and Buffet has espoused this philosophy of investing and looking at price as a very important factor and not timing the market, not trading a lot, but, actually, like you said, buying great businesses and holding them. And then also this idea that most of the world, especially the academic world, was espousing this efficient market theory, which is that all the information is known about the markets and so on so that you can never really get an edge. And yet Buffet was clearly getting an edge, and there was a number of individuals that he highlighted that were also getting an edge. So, that went on for years and years until about four years ago. He shocked everybody by—or three years ago—he shocked everybody by saying, forget all that. Now everybody should go buy index funds.
That’s the point I really want to get to today because that is the shot heard around the world to all these money managers.
Frank Byrd: Absolutely.
Steve Pomeranz: So, take me through that. What are your colleagues saying about that now, now that he’s touting the S&P 500?
Frank Byrd: It’s an interesting question. Honestly, I’m a fairly social being, and I have a lot of friends in the business and, you know, we grab coffee. My sense is you know the New York crowd is still kind of numb; I don’t hear much commentary. This is going to surprise you. Most of my friends, and I am proud to say that I know people that I think of as some of the best in the industry, would tell you that if they were looking over the shoulder of their financial advisor or say their father or their uncle’s financial advisor and they saw that that advisor had them in an index fund, most would say, “Whew!”. I think they’d have a sigh of relief.
There is this acknowledgment that most of the industry is guilty of closet indexing. And when I use that term what I mean, Steve, I’m sure you know what that means, but for those listeners who don’t, closet indexing basically means that a money manager has a portfolio that is constructed so closely to resemble the index in terms of a large number of companies and very close in terms of mix of industries that in essence it basically looks like the index.
Steve Pomeranz: With one major difference and that is the index that you buy costs next to nothing but these people are charging, what?
Frank Byrd: Absolutely. I mean, look, you’ll see different studies. The number has been coming down. I think the last number I saw, you’ll see a number thrown out, I think—don’t quote me on this, of course, this is broadcast—but the numbers are going to be roughly in the neighborhood of 3/4 of 1%. However, what those numbers often don’t capture is that on top of that there is a 12b-1 selling fee that’s typically another 25 basis points or a quarter of a percent. Then there is this hidden cost that nobody talks about, but a few academics have attempted to try to quantify, and that’s the enormous tax that high turnover, meaning a lot of buying and selling in a portfolio, extracts from the returns of an account.
Now there are several studies on this, and they all reach slightly different conclusions but the studies, some of them conclude that the buying and selling friction costs could amount to as much as one percentage point additional drag.
Steve Pomeranz: Yeah. I mean, if you think about it …Let’s just broaden this out a little bit. If you buy General Electric stock and, let’s say, it’s $33 a share and then you want to sell it. Let’s say it’s $32 and ¾, so there’s a quarter of a point difference between what you have to buy it at and what you have to sell it at. That spread is a cost of doing business and that spread is what you’re talking about. It’s that hidden differential between the higher price you have to pay and the lower price you have to sell it at, plus you have to pay taxes on a portfolio that’s managed actively because anybody who owns a mutual fund and gets a tax bill at the end of the year knows that that manager’s been selling stock and you’ve got to pay taxes on the capital gains that were generated.
So, there’s a few things at play here: the manager’s fee, plus the selling fee, you mentioned this 12b-1, plus this bid spread differential, plus the fact that if you have to pay taxes on the gains, it reduces your return. That’s why I think why Buffet likes to hold onto things so long because he says the government basically is subsidizing his taxes.
Frank Byrd: Absolutely. Look, I don’t believe Buffet feels that he has the time to go this much in-depth. I think he’s trying to communicate a very simple, straightforward message, but I think one thing that maybe doesn’t get enough attention is that the S&P 500 turns over, meaning the buying and selling in the S&P 500 is practically zero. And when I say “practically” it’s in the neighborhood of 5%, maybe in some years it could trend up to a 10%, but that’s a very low turnover because the average portfolio manager—the last numbers I saw, at least—were turning their portfolios over a hundred percent. That means that literally they’ve bought and sold the entire portfolio within a year.
Now, what I’ve found ironic is I would go to these Berkshire Hathaway meetings, and you’ll see all these money managers show up and they all seem to listen, very on the edge of their seat, to his every word. And I always thought it was ironic; I’d look around and I’d see people that I knew were very active traders and it just was weird to me that they would get back on that plane and go back to New York and seemingly disregard this buy-and-hold mentality. So, I believe Buffet’s big attraction to the S&P 500 is, at least, he knows it’s low turnover and that means not just a low management fee (which is, of course, very, very low compared to the 1%, the 3/4 to 1 and 1/2% range that a typical money manager’s going to charge) on top of that the S&P 500 is not engaging in a lot of activity and that means less friction costs and less taxes.
Steve Pomeranz: All right. So, here’s a problem that I have, myself being in the business for 35 years and really steering clients towards the creation of wealth and financial planning and this kind of thing, but here’s the problem that I see with this idea of it’s just about the S&P 500. And, by the way, I totally agree that index funds are really the way to go. Very hard for an active manager to capture excess return to justify their fees, no question about it. But I think the average person can’t stand the idea of doing nothing for 25 years because it’s more psychological. I mean, even Buffet said the other day in a CNBC interview, he said that there were three times since he’s owned Berkshire Hathaway that that stock, Berkshire Hathaway stock, has gone down 50%
Now maybe a guy like Buffet can hold on when stocks go down because he really understands the value of the company that he owns and the companies that he buys, but the average person doesn’t have a clue. They see a number rising and falling every day when they check their phone or they check their statements. They don’t have any idea. And when things go bad, everybody’s…Actually, everybody’s asking me these days, “Hey, Steve, is there a time we should sell? This looks like a fake rally to me. Shouldn’t we sell?” I think it’s human nature to ask that question. What do you think?
Frank Byrd: So, first, on the issue of all of a sudden he’s now telling people to be passive investors when over his career he’s been an active investor …
Steve Pomeranz: By the way, I don’t mean to interrupt but he also hires two individuals, Todd and Ted, yes? Why isn’t he investing his company’s money in the S&P 500?
Frank Byrd: The simple answer, Buffet knows active management can work. He knows that it is very rare, not because it is so impossible for some people to consistently do better than average—we know there is a subset of doctors that will consistently do better than average medical care. What I believe is unstated, and I encourage everyone to read the latest Berkshire Hathaway report, he makes no bones about that indexing is not just something that the small investor should be doing, but it’s something the large investor should be doing. I believe the reason—if you read his written statements carefully—it really focuses on this idea that the typical choice to most people is a large money manager, and he is very explicit that size is the enemy of performance.
I call it the conspiracy of scale. You know, the investing public—if you think of them as consumers of Wall Street goods—the dirty secret of our business, Steve, is that the money management business has dis-economies of scale. By that I mean, the more money you manage, the worse your returns are going to be, and because Buffet acknowledges the reality that the big money management firms, which is just practically where most people are going to have to invest their money, all but the index funds are going to give an inferior result.
So, he’s not saying that there aren’t some good money managers out there, but it’s typically going to be the small ones; and for the typical person, even professional investor, to be able to identify in advance the small manager, that they can get into that, by the way, will have the integrity to remain small, meaning, keep themselves closed to new investors past a certain size, he knows that’s not going to happen.
I’ve come into this business as an active manager. I know alphas is possible. I have yet to hire an active manager. I take that back. I hired an active manager for an international allocation and then, Murphy’s Law, he literally retires two months after I hired him. Do you know how hard…you do know how hard it is because you and I are in the same business …you know how hard it is to find active managers where you know you have great confidence as a fiduciary that I am doing a better job giving my clients’ money to this manager over and above an index.
Steve Pomeranz: We got to stop right here. My guest, Frank Byrd, founder of Fielder Capital, and you got to hear a little bit of an insider’s discussion on some of the issues, the investment issues of the day now that Buffet has come out with his annual report as he prepares for the annual meeting in May. We get a chance to talk about one of our favorite subjects; so, Frank Byrd from Memphis, Tennessee, joining me today.
Thank you very, very much. And don’t forget to find out more about Frank and to hear this conversation and interview again, join the conversation at stevepomeranz.com.
Frank Byrd: Thank you, Steve.